Our portfolio tends to be pretty eclectic as we look for what we see as the best investment opportunities, however we have often have specific industry themes within the portfolio. Currently one of our themes is energy, which encompasses oil, natural gas, coal, and related infrastructure. We have been very vocal on our feelings as it relates to oil prices and production and the whole fallacy of U.S. energy independence. But our research has led us to some interesting conclusions in other areas of the energy food chain. Before turning our attention to our coal thoughts, below are our most pertinent summary thoughts on oil markets:
- While light oil production from various shale basins has been impressive, both the costs to bring this production on and the decline rates of wells are very high, helping to set a much higher floor for oil prices. Linear production forecasts for this domestic production are likely to be wrong and both Peritus and a growing chorus of energy analysts believe that this production will peak in the coming 2-3 years.
- Conventional global production continues to struggle. Producers at the margin such as Nigeria, Iran, Iraq, Venezuela and Libya are unstable countries with no capital markets or foreign capital incentives to assist in boosting or even maintaining production rates. Historically, once a country suffers a regime change, production never returns to its old highs.
- Heavy and light oil are two different markets. Much of the refining system has been set up to refine heavy oil. Venezuela and Mexico have historically provided much of this heavy crude to the Gulf Coast. Their production is declining at an alarming rate.
Despite the negative press on Canadian oilsands and conventional heavy production, we believe this area represents the most attractively priced opportunity globally. These are long lived production assets suffering only from a lack of pipelines, which we believe will be rectified in the coming 2-3 years. This crude will ultimately find its way to tidewater and receive Mayan or Brent type (i.e., higher) pricing, allowing for strong profits for these producers.
Let’s now swing our thoughts back to other major players in the energy space: natural gas and coal. Natural gas production has been very prolific and in our view will remain so for the foreseeable future. Long-term, we believe that natural gas pricing will begin to globalize as the LNG (liquefied natural gas) export business takes root. While gas prices in Asia and even Europe are 3-4x what they are in North America, end users such as Japan and South Korea are negotiating very hard for pricing concessions on off-take agreements for U.S. and Canadian LNG exports. In addition to our current holdings in the space, we will work to continue to identify who else we believe wins in the gas game.
What does this all mean for coal? We have certainly seen the negative press and watched the industry struggle with low prices for both metallurgical (steel-making) and thermal (for utilities to generate electricity) coal. But the dirty little secret is that coal usage continues to grow at a rapid pace globally. Today, there are hundreds of gigawatts of coal fired electricity being built across the globe. To feed this machine will require the equivalent of a doubling of U.S. annual production. Where will this production come from?
I have often stated that I thought Darwin was a much better economist than biologist and in the case of the U.S. coal industry, Darwinian economics are at play. There have been a rash of bankruptcies and mine closures and it is not over. But a bottom is clearly forming. With natural gas prices hovering around $4.00, coal is the more attractive choice, even domestically. We have focused our attention on those companies producing thermal coal and have the assets and staying power to be there when the cycle turns up. Additionally, these companies need to have an avenue to export coal to foreign markets as coal fired capacity comes online. We are likely to be wrong on our expectations for coal in the coming years, and would glad to be. As mine closure accelerate and the industry consolidates, pricing is likely to be much higher than we are forecasting.
We are thematic investors and look for industries that we feel are misunderstood or undervalued. Yes there are companies in the coal space who are the weaker players and may not make it through this cycle intact, and we have already seen bankruptcies. But within that there are selective survivors and attractive investments. As active managers, we believe we are able to add alpha for our investors by digging into these misunderstood industries and capitalizing on the selective opportunities within them.